The Empirical Literature on the Efficiency Studies

Mokhtar et al. (2006) investigated the efficiency of fully-fledged Islamic Banks, conventional banks, and Islamic windows in Malaysia. They concluded that Islamic banks were the most cost and profit efficient when compared to both conventional and investment banks. They employed SFA in order to calculate the technical and cost efficiencies of 288 observations from the annual reports of 20 Islamic windows, two full-fledged Islamic Banks and 20 conventional banks over the period from 1997 to 2003. The findings state that, in terms of assets, deposits and financial base, the Malaysian Islamic banking sector developed significantly between 1997 and 2003 relative to the conventional banking counterpart. Islamic banking technical and cost efficiencies were expected to provide major perceptions to management and policy makers with reference to the optimal utilization of capacities and the allocation of scarce resources in different banks (Mokhtar et al., 2006). By running SFA, Al- Shammari (2003) found, also, that Islamic banks were the most cost and profit efficient when compared to conventional commercial and investment banks in GCC countries. Moreover, the author concluded that Bahraini banks were the most cost efficient and Oman banks were the least efficient.

Al-Shammari (2003) represented bank types and country dummy to affect inefficiency directly in order to limit loan quality and capital in both cost and profit functions. Similarly, Al-Jarrah and Molyneux (2003) employed the SFA, with the Fourier-flexible functional form, and found that Islamic banks were more cost and profit efficient than conventional banks. They computed cost and profit efficiency for the banks operating in Bahrain, Egypt, Jordan, and Saudi Arabia. Likewise, Bader et al. (2008) and found that, when compared to their conventional counterparts, the Islamic banks were the most efficient. Moreover, Bader et al., (2008) concluded that

the small Islamic banks were more efficient than the conventional banks due to their capital structure. Between 1990 and 2005, they studied eighty banks of which forty- three were Islamic banks and thirty-seven were conventional banks. The study demonstrated, also, that, since they had gained more experiences firstly, over time, the cost and profit efficiency of older Western banks were more efficient than older Islamic banks (Bader et al., 2008).

On the other hand, Hussein (2004), EI-Gamal and Inanoglu (2005), Alpay and Hassan (2006), and Mokhtar, et al. (2006) found no significant difference in efficiency between Islamic banks and conventional banks. Hussein (2004) investigated the performance of Bahraini banks by determining their profit efficiency using the Fourier’s flexible functional form for the period from 1985 to2001. Afterwards, he compared the profit efficiency of Islamic banks with conventional banks. His findings showed that the profit efficiency of Bahrain banks was relatively stable and in line with the Organization for Economic Co-operation and Development (OECD) banks. Moreover, the researcher concluded that there was not too much of a difference in terms of profit efficiency between Islamic and conventional banks regardless of the fact that many Islamic banks were small and operated as venture capital. In contrast, the only Islamic commercial bank in his sample outperformed the conventional counterparts. This was due to lack of competition whereby the Islamic commercial bank was able to reduce its input costs and charge a higher mark-up. In addition, during the period from 1997 to 2003, Mokhtar, et al. (2006) found no significance difference between companies or merchant banks using cost function and between Islamic banks and all conventional banking institutions using profit function.

However, this Malaysian banking study does not assume any environmental factors either to influence the function or to influence directly the inefficiency. El-Gamal and Inanoglu (2005) found no significant difference in efficiency between Islamic and conventional banks. According to them, this is due to Islamic asset-based financing leading to lower non-performing loans ratios. By employing SFA during the period from 1990 to 2000, El-Gamal and Inanoglu (2005) studied the cost efficiency of fifty- three Turkish banks, forty-nine conventional banks relative to four Islamic Special Finance Houses (SFHs). The Islamic institutions represent around 3% of the Turkish

banking sector (El-Gamal and Inanoglu, 2005). It is significant to mention that, whether or not subjected to many restraints, e.g. branching and the inability to hold government bonds, SFHs were able to attain high levels of efficiency. Using the same dataset, while EI-Gamal and Inanoglu (2005) employed cost function to measure efficiency, Alpay and Hassan (2006) applied DEA to measure the Turkish banks’ efficiency. The study agreed that, on average, Islamic banks were equal, if not more efficient than conventional banks despite having limited Shari'ah compliant investment opportunities. However, unlike conventional banks, the Islamic banks’ productivity and technical efficiency reduced over time.

However, studies by Omar et al., (2007), Mokhtar et al. (2007, 2008), and Srairi (2010) found that Islamic banks were significantly less efficient than conventional banks. Srairi (2010) concluded that, in terms of profit and cost during the period from 1999 to 2007, western conventional banks in the Gulf Cooperation Council (GCC) countries were more efficient than Islamic banks. Srairi employed the SFA to determine the cost and profit efficiency of seventy-one Islamic and western banks in GCC countries between 1999 and 2007. Omar et al. (2007) examined the efficiency of twenty-one privately- owned Indonesian banks (two Islamic banks versus nineteen conventional counterparts) between 2002 and 2004. They found that these two Islamic banks were more cost and profit efficient than the conventional counterparts.

On the other hand, many studies examined only the efficiency of Islamic banks (e.g. Hussein (2003); Yudistira (2004); Mostafa (2007); Kamaruddin et al. (2008); Sufian et al. (2009c)). By employing DEA, Sufian et al. (2009c) examined the efficiency of Islamic banks in 16 Asian and MENA countries, between 2001 and 2006. They found that Islamic banks were operating at a relatively optimal scale of operations but they were managerially inefficient in utilizing their resources to the fullest (Sufian et al., 2009c). The results showed that the Islamic banks’ PTE declined from 2001 to 2003, increased during 2004, before declining again in 2005 and 2006 (Sufian, et al. 2009c). During the period of study, the Islamic bank’s average PTE was 65.4%; this meant that these banks could save 34.6% of their inputs to produce the same current amount of outputs. By using DEA, Kamaruddin et al. (2008) examined the performance of Islamic banking operations in Malaysia in order to determine the cost and profit

efficiency of two fully-fledged Islamic banks and twelve Islamic windows operations of domestic and foreign banks between 1998 and2004. The findings indicate that the overall cost efficiency estimate is 0.695. This means that when compared to a best practice bank, an Islamic bank wasted 30.5% of its inputs in producing the same current outputs. Yudistira (2004) employed DEA to study the efficiency performance of eighteen Islamic banks between 1997 and 2000. He found that Islamic banks presented significant overall efficiency during the sample period. The study showed that 2000 was the most efficient (0.909) year when compared to 1997, 1998 and 1999 (0.902, 0.870 and 0.897 respectively).

Furthermore, Islamic banks, operating in the Middle East, were less efficient than Islamic banks operating outside the region since the latter were relatively new and were controlled by their respective regulators (Yudistira, 2004). Moreover, the study confirmed that there was a direct relationship between bank size and Variable Return to Scale (VRS) since the findings showed that large Islamic banks were responsible for scale inefficiency. It showed, also, that newer Islamic banks were less efficient than older Islamic banks, whereas the older banks, operating in western countries, were more cost and revenue efficient than their newer counterparts (Yudistra, 2004). The explanations of these findings could be related to the fact that older banks had more experience of the banking industry. By employing SFA, Hussein (2003) investigated the cost efficiency of seventeen Islamic banks in Sudan where the banking system complies entirely with Shari’aprinciples-. The study covered a period of ten years (1990-2000). In his analysis, Hussein (2003) used the specific terms of Islamic financial instruments as outputs. The findings present significant differences in the Sudanese banks’ cost efficiency. Moreover, they demonstrate that foreign- owned banks are the most efficient among Sudanese banks. The study a observed, also, the determinants of bank efficiency where Hussein (2003) concluded that smaller banks were more efficient than their larger counterparts. Moreover, banks, holding greater levels of Al-Musharakah and Al-Mudarabah in total assets, may benefit from a higher level of efficiency (Hussein, 2003).

On the other hand, studies (e.g. Johnes et al., (2014), Abdul-Majid et al. (2008; 2010; 2011) concluded that Islamic banks were less efficient than their conventional

counterparts. By employing the financial ratios analysis and DEA, Johnes et al. (2009) estimated the efficiency of Islamic versus western banks operating in the Gulf Cooperation Council (GCC) countries. The study examined the performance of six banks between 2004 and 2007. The findings demonstrate that, when compared to western banks, Islamic banks have lower cost efficiency but relatively higher revenue and profit efficiency (Johnes et al., 2014). By conducting SFA, Abdul-Majid et al. (2008; 2011) studied Malaysian banks’ gross and net efficiency. Unlike net efficiency, gross efficiency is computed by considering each bank’s various characteristics in the SFA’s function (Abdul-Majid, 2011). The findings deduced that both the gross and net efficiency of conventional banks are relatively higher than their Islamic counterparts and that the dummy variable for Islamic banks shows significant differences (Johnes et al., 2014).